High Frequency Trading May Be Making Things Worse On Stock Markets

The world’s stock markets have seen near-record levels of volatility this week and last, and there is no shortage of reasons to explain why: From the U.S. debt ceiling debacle to the Eurozone’s credit problems, the world’s economies seem literally booby-trapped with risks to investors.

But some market experts are pointing the finger to yet another cause for the unpredictable up-and-down nature of the markets: High frequency trading, or HFT -- computer algorithms that buy and sell stocks in nanoseconds.

Since HFT came in to use about half a decade ago, it has been blamed for numerous bizarre and unsettling events on the stock markets, and now some insiders are saying it’s making the stock market more volatile. As of this spring, HFT accounted for 56 per cent of trades on the New York Stock Exchange.

In a speech this week, David Gonski, chairman of the Australian Securities Exchange, said high frequency trading is magnifying the wild up-and-down swings in stock markets. He added that HFT is changing the relationship between investors and companies, because with high frequency trading the average shareholder stays invested in a company for 20 minutes.

Sal Arnuk, co-founder of Themis Trading, agrees with that assessment.

"We’re seeing 3 per cent and 5 per cent moves -- the moves would have been half that without high-frequency trading,'' he told USA Today. "You'd still have the moves up and down -- that's the natural flow of the markets, but because of the outsized role of (exchange traded funds) and the increasing role of high frequency trading and how they prey on (investors), these moves become more outsized."

HFT works in a way many observers have described as fundamentally unfair, as it involves computers taking a “peek” at trade orders 0.3 seconds before they’re made, allowing the computers to push the stock price to the highest investors are willing to pay -- or, in other circumstances, to push it down as far as it can go.

Imagine if eBay had a rule where you could cancel your bid within 1 second. I put up some stuff on ebay, and you place a bid for it. Then I place a bid that is higher than the current bid to see if that becomes the new highest bid. If it is, I cancel it within milliseconds. Remember, I don't want to buy the product -- I just want to drive the price higher! This is similar to what critics of HFT think is going on; HFT is able to ping prices with bids that exist for only milliseconds to see how much other buyers are willing to pay to squeeze out the maximum profit.

Since it came in to use, high frequency trading has been blamed for some bizarre occurrences on the markets. It is widely believed to have caused the Flash Crash of 2010, when on May 6, 2010, the Dow Jones dropped 600 points in five minutes.

Earlier this year, The Financial Times reported that HFT algorithms are scouring the internet looking for trending keywords that could affect stock prices. But on at least one occasion the algorithms got it all wrong -- seeing that a news story on actress Anne Hathaway was getting a lot of attention, the algorithms went on a spending spree, buying up shares of Warren Buffet’s Berkshire Hathaway.

The odd problems that HFT is causing, along with concerns that computers’ practice of “peeking” at trades in advance are distoring the market, have caused some to call for an outright ban on the practice.

And this week it was reported that the U.S. Securities and Exchange Commission has subpoenaed companies involved in HFT to probe last year’s flash crash. The names of the companies subpoenaed were not released, and there is no word yet on what the agency plans to do with HFT.

Here's my question: the markets went up in a straight line from August last year to February. Did high frequency trading cause the markets to go up, too? How come I didn't hear people coming on our air saying, "Thank you, high frequency traders, for our rally!"?

But even Pisani admitted that he believes "that at the margins, high frequency trading exacerbates the price swings on high volume days."